When Are Lawsuit Proceeds Taxable?

The answer: it depends.

Tax rules in the United States look to the “origin of the claim” to determine whether funds paid in connection with a lawsuit are taxable. For example, damages paid in satisfaction of lost income would be taxable because the claim originated in the loss of monies that would have been taxable if earned under normal conditions. On the other hand, lawsuit proceeds are tax-free when received “on account of personal physical injuries or physical sickness.”

In tort cases with substantial physical injuries (vehicle collision, slip and fall, etc.), the rules are easily applied. In cases involving less obvious claims for damages, Section 104(a)(2) of the Internal Revenue Code leaves serious uncertainty. For example, the meaning of “on account of” and “physical” has evolved significantly over the years. In 1986, the Tax Court first held that Section 104(a)(2) applies only to compensation received for violations of rights held “by virtue of being a person.” In 1993, the Court expanded this definition in another case in its ruling that harm to personal property (such as a car), is not a “personal” injury. In the latter instance, the court was looking for an “injury to the person, of which bodily harm is the clearest example.” Seems simple enough, right?

However, some cases blur the line between person and property. For example, in a 2015 case involving compensation received for the extraction of human eggs for donation, the IRS treated the donated tissue as “property.” In response, the taxpayer countered that Section 104(a)(2) made her compensation tax-free because it paid for the “pain, suffering, and physical injuries she endured as part of the egg-retrieval process.”

The Court sided with the IRS, finding the taxpayer’s compensation to be subject to tax as payment for the “performance of services.” In its reasoning, the Court stopped just short of treating an egg donation as the sale of “property,” much like its previous treatment of blood donations. The distinction lay in the fact that the plaintiff’s contract conditioned her payment “solely on how far into the egg-retrieval process she went” and not on the “quantity or the quality of the eggs retrieved.” This case highlights the uncertainty which can result from a recovery on multiple simultaneous claims.

What about attorney’s fees?

In 2017, the Tax Cuts and Jobs Act changed the rules governing taxation of lawsuit recoveries by phasing out the entire class of miscellaneous itemized deductions. As a result, most plaintiffs lost the ability to deduct legal fees (except in cases involving violations of traditional civil rights or laws regulating the employment relationship). Without this deduction, a victory in court can become a financial loss. Consider an extreme example:

Recovery (settlement or at trial)                                                          $1,000,000

Non-deductible attorney’s fees of 40% (typical)                                     (400,000)

Non-deductible lawsuit costs (experts, research, etc.)                           (200,000)

Taxes on recovery (high tax state)                                                         (500,000)

Net loss to plaintiff                                                                                ($100,000)

Tax planning pays off

An experienced attorney or accountant can help you plan to structure your recovery for a smaller tax bill. While non-deductible expenses usually cannot be shifted in a way that restores their deductibility, other steps might help. Tax planning can be as simple as changing the way a settlement payment is allocated among various claims or can involve a long term planning tool such as an annuity or trust.

If you are concerned about taxation of a large settlement, contact us for help.